How Does Interest Work?

There are several different ways to calculate interest, and some methods are more beneficial for lenders. The decision to pay interest depends on what you get in return, and the decision to earn interest depends on the alternative options available for investing your money.

When borrowing: To borrow money, you’ll need to repay what you borrow. In addition, to compensate the lender for the risk of lending to you (and their inability to use the money anywhere else while you use it), you need to repay more than you borrowed.

When lending: If you have extra money available, you can lend it out yourself or deposit the funds in a savings account (effectively letting the bank lend it out or invest the funds). In exchange, you’ll expect to earn interest. If you are not going to earn anything, you might be tempted to spend the money instead, because there’s little benefit to waiting (other than saving for future expenses).

How much do you pay or earn in interest? It depends on:

  1. The interest rate
  2. The amount of the loan
  3. How long it takes to repay2

A higher rate or a longer-term loan results in the borrower paying more.

Example: An interest rate of five percent per year and a balance of $100 results in interest charges of $5 per year assuming you use simple interest. To see the calculation, use the Google Sheets spreadsheet with this example. Change the three factors listed above to see how the interest cost changes.

Most banks and credit card issuers do not use simple interest. Instead, interest compounds, resulting in interest amounts that grow more quickly (see below)

Add a Comment

Your email address will not be published. Required fields are marked *